The FINANCIAL -- The bouts of sharp lari depreciation in the recent months caused much anxiety among the population, prompting fears of inflation, loan defaults, bank failures, and the typical Georgian political speculations over “who is to blame”.
The worst thing that could happen would be a veritable financial crisis triggered off by the exchange rate turmoil.
Economic literature identifies three main types of financial crises: currency crises, banking crises, and “twin crises”, i.e. a banking crisis brought about by a currency crisis. A currency crisis is characterized by domestic debtors, both companies and households, defaulting on their loans denominated in foreign currency. A banking crisis is a situation where the trust in the banking system deteriorates, causing withdrawal of deposits and causing banks to collapse.
While all three types of crises do damage to the economy, the twin crises are known as the most severe – they are typically associated with significant and protracted recessions, which can last as long as 4 years and typically eat up about 20% of GDP (cf. Bordo et al., “Is the Crisis Problem Growing More Severe?”, Economic Policy 16, 2001).
How likely are these horrible scenarios? One of the best ways to quickly assess the health of the banking sector of a country is to look at a set of figures commonly known as Financial Soundness Indicators (FSIs). The FSIs are compiled according to IMF guidelines and they are comparable across countries. Let us check some of them.
HOW VULNERABLE ARE GEORGIAN BANKS?
The capacity of the banking sector to cope with a worsening of the financial climate is captured by the Capital to Risk-Weighted Asset Ratio (CRAR) shown for several countries in Figure 1.
This indicator tells us how much capital the banks have relative to their risky assets, such as loans, which are weighted with their risk exposure. Everything remaining equal, the more risky the loans, the higher is their weight, and the lower will be the CRAR. Higher risk requires a bank to retain more capital to safeguard against potential losses, and thus the CRAR summarizes how well a banking sector is prepared to deal with a worsening financial environment. Under the Basel III international regulatory banking standard, which was adopted after the financial crisis of 2008, the bank capital should be at least 8% of the risk-weighted assets of a bank. As we can see, in Georgia this ratio is well above 8%, similar to that of Denmark and Germany.
Another figure which informs us about the risk exposure – and thus the vulnerability – of the banking sector is the share of non-performing loans to total gross loans.
This is an important indicator for the general climate in which banks are operating. If the share of nonperforming loans increases, banks, in particular those which are already suffering on other fronts, may run into serious trouble. Those countries whose financial sectors are in “stormy waters”, like Greece and Cyprus, have indeed very high rates of non-performing loans of more than 35% and 40%, respectively.
Yet again, the situation in Georgia is totally unproblematic, as can be seen in Figure 2. In Georgia, the share of nonperforming loans is low, both compared with other countries and compared to previous points in time. It is even lower than in 2013, and that is true if one applies the very strict NBG standards (which classify a loan as nonperforming if the payment is overdue by 30 days, as opposed to 90 days by IMF standards).
Finally, one may be concerned about the trust economic agents have into the banking sector. This is an important issue, as every financial system, even the most solid one, can be brought down if it runs into a trust crisis. In finance, pessimism can quickly turn into a self-fulfilling prophecy if people are concerned about the safety of their deposits. Money will be withdrawn, as could be seen in Greece in the last two months, and if this dynamic gets out of control, it may turn into a veritable bank run, causing the most solid banking sector to crash.
Yet again, in Georgia there is absolutely no reason for concern. The Business Confidence Index (BCI) for the Georgian financial sector, shown in Figure 3, is not bad at all. The BCI is a measure of the expectations economic agents have about the future of a whole economy or one of its sectors and as such can be taken as an indicator of trust.
As shown in the figure, since almost one year the business confidence within the financial sector is considerably higher than the general business confidence. In addition, a further decomposition of the data reveals that the financial sector firms also have strongly positive expectations about the future (not shown in the figure), and these expectation have taken another upturn in the first quarter of 2015.
HOW TO PREVENT A CURRENCY CRISIS
While there is no banking crisis looming, what about a currency crisis? Will the lari depreciation lead to a wave of defaults in the near future?
First of all, let us emphasize that we are not saying that the only trouble caused by the lari depreciation is of a financial nature – obviously, people are hit by increasing prices, in particular for imported goods, reducing their purchasing power. However, it will not shake the financial sector if the reduced purchasing power of ordinary Georgians dampens their consumption.
On the other hand, what can cause a currency crisis is a situation where households and firms get into so much strain that they cannot serve their debts anymore. Debtors who have borrowed in dollar but make their income in lari may come under severe distress through the devaluation. This is the case for more than half of all loans in the Georgian economy. As shown in Figure 2, so far such a development has not yet set in, but one should be very cautious to keep this risk at bay, as the rate of nonperforming loans is not a linear function of the lari depreciation. Rather, it can evolve explosively once a certain threshold is crossed. While almost all loans are still served when the lari depreciates by some amount, big groups of debtors may default at the same time when that threshold is exceeded.
One possible policy solution to prevent such a development would be if banks would extend the maturity of current dollar loans. In the current situation, this would be a win-win for both debtors and banks. While an extension of maturities is roughly cost-neutral for the banks, it relieves the pressure for debtors and reduces the risk of default. Figure 4 shows how the maturity affects the monthly payments that have to be made.
If you are borrowing at the average USD interest rate of 12.3% and your loan is of an average maturity, which currently is 16.7 months in Georgia, then your monthly payment is around $555. If the maturity would be extended to 24 months, the monthly payment would be reduced to $400, while a 3-year maturity would drop the payment to $283. Clearly, a move to extend USD loans maturity would reduce pressure on household finances and prevent a surge in default rates caused through the lari depreciation.
It should also be noted that extending maturities of existing loans tends to be a greater relief for borrowers than the possible alternative of subsidizing interest on loans. First of all, a subsidy is expensive -- it would either have to come from the government or the banks, both of which might need the money to counter consequences of negative economic developments in future. More important, however, is the fact that even heavy subsidies do not reduce the monthly payments by a great deal. If one would want to reduce the monthly payment from $555 to, say, below $530, would have to reduce the effective interest rate by more than 6 percentage points, i.e. less than half of its current level.
NO REASON TO PANIC
The recent development of the lari exchange rate is disconcerting for a couple of reasons, but not because we are on the verge of a financial crisis. A sober economic analysis does not support concerns of that kind, and panicking would be totally unjustified.
Nevertheless, banks would be prudent to take precautions now to relief financial pressure from debtors and in this way keep default rates low, so that even the fears of a crisis will be stifled in embryo.